Today's Tidbits

Economists’ FOMC Expectations
From Dow Jones: “Wall Street’s biggest banks are unanimous in expecting the Federal Reserve to cut interest rates when policy makers meet on Tuesday. A Dow Jones Newswires survey of 18 of the 20 primary dealers found that all respondents expect the Federal Open Market Committee, the central bank’s rate setting arm, to lower the funds rate to 4.25% from 4.50%. The survey was done Friday in the wake of the release of a respectable November employment report, which economists concluded was not strong enough to stop the central bank from cutting rates. The primary dealers, which do business directly with the Fed, also largely expect policy makers to make their chief emergency funding source cheaper Tuesday, by lowering the discount window lending rate to 4.50% from 5%. If forecasters are right, a rate cut Tuesday would amount to a full percentage point’s worth of monetary policy easing since September… The economists in the survey by and large don’t think December will represent the last rate cut either. The median projection of the survey is for the funds rate to hit 4.0% at the conclusion of the January FOMC meeting, and to move to 3.75% by the June policy gathering, which is where the median expectation puts the 2008 year end funds rate as well.”

House Prices Up To 30% Over Historic Relationship to Rents and Incomes (=$6 Tr)
From The Wall Street Journal: “House prices are down by 0.5% to 10% now, depending on the measure used. If they fell 30% -- what it would take to restore their historic relationship to inflation, rents and incomes -- $6 trillion worth of housing wealth would be wiped out. Measured against the size of the U.S. economy, that is less than what was lost in the stock market between 2000 and 2002. Initial guesses at total losses on subprime and similar mortgages range from $150 billion to $400 billion. The latter figure would equal about 3% of U.S. annual economic output. That is similar to the losses suffered by S&Ls and commercial banks between 1986 and 1995. But it is less than half the scale of Japanese bank losses in the wake of that country's burst stock and real-estate bubbles. The current crisis, though, differs in crucial ways from the recent tech-stock bust and the S&L crisis. For one, it centers on assets -- houses -- that, unlike stocks, most people have bought with borrowed money. On average, mortgage debt amounts to nearly half the value of houses. In recent years easy credit has allowed many to borrow up to the full value of their homes, making them more leveraged than any hedge fund. As prices fall, people who find themselves owing more than their homes are worth are much more likely to renege on their mortgages, leaving lenders to sell the foreclosed houses at a loss. To make matters worse, payments on more than $500 billion in mortgages will reset in 2008, mostly to higher rates. Banks are far less exposed to serious damage than during the 1980s. Nonetheless, the shift of loans from banks to markets has created a staggering complexity that threatens to prolong the crisis… Nationally, there were 2.1 million vacant homes for sale in the third quarter, equal to 1.6% of all the homes in the country – a record. At the end of 2006, the value of all homes in the U.S., excluding rentals, peaked at 153% of gross domestic product (or about $21 trillion) -- the highest level in at least six decades. By Sept. 30, that had edged down to 150% of GDP as home prices began to drop. With huge inventories of unsold homes soon to swell with foreclosed properties, that is likely to continue. Falling home prices make consumers poorer and less ready to spend, and they make it harder to borrow against home values -- even if consumers are current on their payments… Mortgage securities typically consist of 10 or more different slices – from highly rated slices for conservative investors all the way down to low-rated, riskier slices for investors looking for bigger returns. Each slice has its own set of rules governing when and how investors will get paid or suffer losses.
Rising defaults can actually be good for some highly rated slices, which get paid off faster as a result. Many lower-rated slices, though, pay back the original investment only after three years, and only on the condition that defaults remain low. That means the value of a security issued in 2006 stands to be a big question mark until 2009… after years of living off the debt-financed increases in the value of their homes, U.S. consumers are in uncharted territory. "A lot of people, including me, have been saying that the country has been spending more than it's been producing, and that will have to come to an end," says Mr. Volcker. "The question is: Does it come to an end with a bang or whimper?"”

House Price Declines Most Important Determinant of Future Foreclosures
From Merrill Lynch: “There has been considerable research done showing that the principal cause of mortgage foreclosures, by the way, is not the level of the FICO score or whether someone is prime, Alt-A or subprime, but rather the loan-to-value ratio - which in turn is principally driven by the direction of home prices (a San Francisco Fed paper, released just last Friday, shows statistical evidence of this). Default rates will continue to rise as home prices depreciate. If we are correct that house values, on average, have a further 10% downside potential in the next year after already declining more than 5% in the past year, then "Hope Now" is destined to morph into "Default Later". The premise of the plan is flawed to begin with since it assumes that foreclosures can be prevented by re-working the interest rate, but as long as home prices depreciate, we can expect default and foreclosure rates to hit new highs in the coming year with or without this initiative. ”

Recession Risk
From Morgan Stanley: “A mild US recession is now likely, with no growth for the year ahead. Three factors have tipped the balance: Financial conditions are tighter, the weakness is broadening into capital spending, and global growth is slowing. We expect the Fed to reduce short-term rates by at least 100 bp from current levels…US housing and consumer weakness are well recognized. But the coming weakness in business capital spending and slowing in overseas growth is not. Tighter financial conditions and falling earnings will hurt capex, while US spillovers and slowdowns in Europe and Japan will undermine growth abroad. Market implications: A more aggressive Fed, an earnings recession, healthy growth abroad, and a scramble for liquidity all will reinforce our longstanding market calls for steeper yield curves, higher volatility, and challenges for risky assets. While many of these themes are in the price, economic uncertainty may extend them further. But …despite the downturn, US stocks may outperform and the dollar should rally. Those conclusions are out of consensus and not in the price.”
From Merrill Lynch: “In our view, the consumer is on the precipice of experiencing its first recessionary phase since 1991 - the last time we had the combination of punishingly high energy prices, weakening employment conditions, real estate deflation, and tightening credit conditions.”
From Citi: “Expectations for easing have built in the wake of comments from Fed officials linking financial market strains to increased downside risk to growth and potentially lower interest rates. Significantly, back-loading of expected interest rate cuts has begun to ease over the past several sessions pointing to considerably more 'optimism' that Fed responsiveness will be sufficient to forestall more severe fallout from market volatility. We believe this confidence may be misplaced. Fed action thus far has done little to reverse underlying weakness in US housing markets or offset financial market stresses. Against this backdrop it may be difficult for the Fed to contain volatility and there is likely significant scope for policymakers to disappoint markets. As money markets discount only a small probability of a 50 bps move, the statement accompanying a 25 bps cut may be key in marking the line between a 'dovish' and 'hawkish' outcome. Failure to provide guidance that intensification of market stresses could translate to additional near-term easing may be interpreted as hawkish…Fed dovishness might only reinforce the trend towards a softer USD.”

New Freddie Buyback Policy to Conserve Capital
From Deutsche Bank: “Freddie announced today that it will be more restrictive in its regular business activity of buying loans out of PC pools (normal Freddie MBS pools). The point of the new restrictions is to preserve capital. The reason they are announcing these modifications to the normal practice is to be transparent which is important in this market climate. Instead of simply buying loans that are 4 months delinquent out of pools and putting them into the capital intensive retained portfolio, Freddie will require that one of the 4 conditions are met: 1) the mortagage has been modified, 2) a foreclosure sale occurs, 3) the mortgage has been delinquent for 2 years, 4) the cost of paying the coupons and principal exceeds the cost of holding the loan in the portfolio. In terms of prepayment speeds, it may increase prepayments on high premiums, and lessen their duration, but slightly decrease the prepayment speeds on discount coupons, increasing their duration. Given the high premium's small size relative to the market, this is not likely to dampen the overall extension trends.”

WAMU Selling Convertible Stock and Shedding Jobs
From Bloomberg: “Washington Mutual Inc., the largest U.S. savings and loan, plans to raise $2.5 billion and cut about 3,150 jobs as losses from the mortgage market increase.
The Seattle-based lender will sell convertible stock and close 190 of 336 home loan centers, the bank said in a statement on Business Wire today. It will also cut its quarterly dividend to 15 cents a share from 56 cents.”

MBIA Boosts Capital
From Bloomberg: “MBIA Inc., seeking to avert a crippling reduction of its AAA credit rating, will receive as much as $1 billion from private equity firm Warburg Pincus LLC. Shares of MBIA, the world's biggest bond insurer, soared as much as 27 percent after the company said it will sell $500 million of common stock…The added capital may help ward off a cut in MBIA's top credit rating, which is under scrutiny by Moody's Investors Service, Fitch Ratings and Standard & Poor's. MBIA's AAA ranking stands behind $652 billion of state, municipal and structured finance bonds and losing the AAA credit rating would endanger those ratings, as well as cut off MBIA's ability to guarantee debt, its main source of revenue…Credit-default swaps tied to MBIA dropped 95 basis points to 330 basis points, the lowest since Oct. 30…The ratings firms are examining at least eight bond insurers on concern that a slide in the credit quality of some of the 80,000 securities they guarantee requires them to hold more capital to justify their AAA ratings. Bond insurers charge to underwrite debt and give it an effective AAA ranking, allowing issuers to borrow more cheaply. The insurers guarantee $2.4 trillion of debt and downgrades could cause losses of $200 billion, according to Bloomberg data. MBIA insures state, municipal and structured finance bonds, including mortgage-backed securities and collateralized debt obligations, securities that repackage pools of debt into slices with varying ratings and risk. The insurer is among some of the biggest U.S. financial institutions seeking money from outside investors to shore up capital after the value of subprime mortgages and CDOs slumped, causing more than $66 billion of losses.”
From Citi: “Moody's have warned of a capital shortfall at monoline insurers including MBIA, AMBAC and CIFG among others. The monolines insure about $3.3tr dollars of debt and analysts are predicting that they will require capital injections to ensure their continued AAA ratings. Downgrades for the monolines could trigger a vicious circle of firesales and falling asset prices in the bonds they insure.”

New Job Creation Deteriorating Toward Recessionary Levels
From Merrill Lynch: “…the payroll diffusion index, which measures the dispersion of job creation, has fallen sharply in recent months. It has dropped below the 50% mark to 49.8…A reading below 50% means that even though total payroll growth was positive, there were actually more industries shedding jobs than adding to them in November. We seem to recall that this number slipped below 50 for the first time in the last cycle in February 2001, a month before the recession began… The year-over-year growth rate in nonfarm payrolls continued to decelerate, to now +1.1% in November, versus +1.7% a year ago and its peak of +2.1% in March 2006… the year-over-year pace is the same now as it was when the last official downturn started in the first quarter of 2001, and lower than it was when the recession before that commenced in 3Q1990 (the YoY payroll trend that quarter was 1.40%).”

A Favorite Inflation Indicator of the Fed
From Bloomberg: “Sack, head of monetary and financial market analysis at the Fed in 2003 and 2004, uses a chart that plots forward rates measuring investor expectations for inflation in five years. The gauge is so accurate that Sack and his colleagues persuaded the central bank to use it to help set policy… Right now, it shows current Fed Chairman Ben S. Bernanke may have less room to lower borrowing costs than investors in Treasuries anticipate, potentially setting bondholders up for a fall. The expected inflation rate, which Sack says replicates what Fed officials use, reached 2.91 percent last week, the highest since 2004, when the central bank began the first of an unprecedented 17 rate increases. The measure was at 2.79 percent on Nov. 1. ``One of the defining features of the Bernanke Fed to date is its emphasis on measures of longer-term inflation expectations,'' said Sack, whose partners at Macroeconomic Advisers LLC include former Fed Governor Laurence Meyer. ``The Fed is willing to tolerate short-run movements in inflation, but only as long as those movements don't appear to be dislodging long-run inflation expectations.'' Any evidence that accelerating inflation is becoming entrenched may heighten the Fed's debate… The gauge used by Sack, dubbed the five-year five-year forward breakeven inflation rate, suggests bets on lower Fed funds rates may be too bold… ``The market, by keeping the same inflation expectations while lowering growth expectations, is implying there are inflationary pressures,''… Bond investors are demanding about 1 percentage point more in yield to own Treasuries maturing in 10 years than due in two years to compensate for the risk that consumer prices will accelerate. There was no difference as recently as June. Sack and other analysts derive the measure of inflation expectations from yields on five- and 10-year Treasury Inflation Protected Securities and Treasuries. Fve-year TIPS yield 2.17 percentage points less than five- year notes. This so-called breakeven rate is the average inflation rate investors expect over the next five years. The forward rate projects what the breakeven will be in five years, smoothing blips in inflation expectations from swings in oil prices or other events. The five-year TIPS' breakeven rate rose to a six-month high of 2.47 percent Nov. 27, the week after oil climbed to a record $99.29 a barrel, from about 1.9 percent on Aug. 31. As crude fell to a six-week low on Dec. 6, the breakeven rate declined and Sack's measure dropped to 2.86 percent on Dec. 7… The five-year forward rate is among the Fed's ``weapons'' in modeling the economy, alongside measures of output and productivity…Bernanke mentioned the forward rate in a 2004 speech. Simon Kwan, a vice president at the San Francisco Fed, singled out the measure in a 2005 report, saying it ``captures the market's assessment of how well the Federal Reserve promotes price stability in the long run.''… The government may say this week that consumer prices, which set TIPS rates, increased 4.1 percent last month from this year's low of 2 percent in August and the biggest rise since July 2006, according to the median estimate of 34 economists. Food, imports and energy prices may raise inflation expectations, Bernanke said in a Nov. 30 speech… ``Inflation will not go away as an underlying concern for the Fed, and that is one reason we are expecting a 25-basis-point cut, rather than 50 basis points,''…”

Rising Wealth and Energy Demands Push Food Inflation to 150 Year High
From The Economist: “…the end of cheap food. In early September the world price of wheat rose to over $400 a tonne, the highest ever recorded. In May it had been around $200. Though in real terms its price is far below the heights it scaled in 1974, it is still twice the average of the past 25 years…The Economist's food-price index is now at its highest since it began in 1845, having risen by one-third in the past year…world cereals stocks as a proportion of production are the lowest ever recorded. The run-down has been accentuated by the decision of large countries (America and China) to reduce stocks to save money. Yet what is most remarkable about the present bout of “agflation” is that record prices are being achieved at a time not of scarcity but of abundance. According to the International Grains Council…this year's total cereals crop will be 1.66 billion tonnes, the largest on record and 89m tonnes more than last year's harvest, another bumper crop. That the biggest grain harvest the world has ever seen is not enough to forestall scarcity prices tells you that something fundamental is affecting the world's demand for cereals… The use of grains for bread, tortillas and chapattis is linked to the growth of the world's population. It has been flat for decades, reflecting the slowing of population growth. But demand for meat is tied to economic growth and global GDP is now in its fifth successive year of expansion at a rate of 4%-plus. Higher incomes in India and China have made hundreds of millions of people rich enough to afford meat and other foods. In 1985 the average Chinese consumer ate 20kg (44lb) of meat a year; now he eats more than 50kg. China's appetite for meat may be nearing satiation, but other countries are following behind: in developing countries as a whole, consumption of cereals has been flat since 1980, but demand for meat has doubled…Calorie for calorie, you need more grain if you eat it transformed into meat than if you eat it as bread: it takes three kilograms of cereals to produce a kilo of pork, eight for a kilo of beef. So a shift in diet is multiplied many times over in the grain markets…Because this change in diet has been slow and incremental, it cannot explain the dramatic price movements of the past year. The second change can: the rampant demand for ethanol as fuel for American cars…This year the overall decline in stockpiles of all cereals will be about 53m tonnes—a very rough indication of by how much demand is outstripping supply. The increase in the amount of American maize going just to ethanol is about 30m tonnes. In other words, the demands of America's ethanol programme alone account for over half the world's unmet need for cereals. Without that programme, food prices would not be rising anything like as quickly as they have been. According to the World Bank, the grain needed to fill up an SUV would feed a person for a year…For decades, prices of cereals and other foods have been in decline, both in the shops and on world markets. The IMF's index of food prices in 2005 was slightly lower than it had been in 1974, which means that in real terms food prices fell during those 30 years by three-quarters. In the 1960s food (including meals out) accounted for one-quarter of the average American's spending; by 2005 the share was less than one-seventh. In other words, were food prices to stay more or less where they are today, it would be a radical departure from a past in which shoppers and farmers got used to a gentle decline in food prices year in, year out. It would put an end to the era of cheap food. And its effects would be felt everywhere, but especially in countries where food matters most: poor ones…There is one last important knock-on effect of agflation. It is likely to help shift the balance of power in the world economy further towards emerging markets. Higher food prices have increased inflation around the world, but by different amounts in different countries. In Europe and America food accounts for only about one-tenth of the consumer-price index, so even though food prices in rich countries are rising by around 5% a year, it has not made a big difference…In poor countries, in contrast, food accounts for half or more of the consumer-price index (over two-thirds in Bangladesh and Nigeria). Here, higher food prices have had a much bigger impact. Inflation in food prices in emerging markets nearly doubled in the past year, to 11%; meat and egg prices in China have gone up by almost 50% (although that is partly because pork prices have been pushed up by a disease in pigs). This has dragged up headline inflation in emerging markets from around 6% in 2006 to over 8% now. In many countries, inflation is at its highest for a decade. Central bankers are determined to ensure that what could be a one-off shift in food prices does not create continuing inflation by pushing up wages or creating expectations of higher prices. So they are tightening monetary policy.”

MISC
From Bloomberg: “UBS AG today said it will write down its portfolio by $10 billion and sell stakes to investors in Singapore and the Middle East.”
From JP Morgan: “No doubt, the $10/bbl fall in the price of oil since late November will help to put some holiday cheer back into consumers’ pockets.”

From RBSGC: “MBS holdings by US banks increased $8 bn with pass-through holdings up by $1 bn and CMO holdings up by $7 bn. MBS holdings were down $34 bn since the start of this year. Deposits decreased $42 bn over the past week. Since the start of this year, deposits increased $453 bn. Commercial and industrial loans increased $4 bn for all banks over the week. Since the start of the year, C&I loans increased $234 bn. Whole loan holdings increased $10 bn over the week. Since the beginning of the year, whole loan holdings increased by $204 bn.”

From Deutsche Bank: “1M LIBOR has again set slightly lower, continuing the trend of the past 4 days.”

From Citi: “The US ABCP spread has soared over the last week to levels (310bp) last seen at the height of the crisis in mid-August. S&P have joined Moody's in mass downgrades for SIV paper by cutting its ratings on all the capital notes issued by the SIVs it rates. Last week Moody's announced that it had downgraded or put on review SIV debt totalling $119bn.”

From Citi: “The extreme level of inversion [Fed Funds and 2 year yields] was at 171 b.p.s on 4th December, reflecting the ineffectiveness of the 75 b.p.s cuts from the Fed
since September. Now the curve is inverted by some 142b.p.s, very similar to the level of inversion before the September FOMC meeting. As a result, from this chart, we would not be surprised to see a 50 b.p.s cut in the Fed Funds Target Rate this month, which could be a catalyst for further USD weakness.”

From Dow Jones: “Sears Holdings Corp. (SHLD) and Restoration Hardware Inc. (RSTO) said that the two parties recently entered into a confidentiality agreement. The news came as Restoration Hardware, a home-furnishings retailer, said its fiscal third-quarter net loss widened on weaker consumer spending and lower traffic levels.”

From Deutsche Bank: “Our US economics team is hesitant to call a trough in housing this early, however - they expect the market to trough around the middle of next year. They note that it is difficult to get an accurate fix on activity in the market outside of the main selling season. But …thanks to declining home prices and Fed easing, respondents to the University of Michigan's consumer survey were more upbeat about current house-buying conditions in December than at any time since May (or perhaps we should say less downbeat). So it is possible that we are entering the `troughing' phase. We note that the S&P homebuilders index has rallied 32% over the past fortnight. That only takes the index back towards where it was in late October. But the index does now appear to be breaking up.”

End-of-Day Market Update

From RBSGC: “Price action was more of the same -- grinding weakness and the curve unable to sustain steepening momentum (or build on flattening momentum for that matter)… an urge to take balance sheets down inhibits a willingness to take on a position and so makes the price action volatile and potentially misleading.”

From Deutsche Bank: “US equities shrug off UBS's USD10bn subprime writedown as Singapore Govt & Middle East Investor inject USD11.5bn of capital, sees financial stocks lead the mkt higher. Debt yields modestly higher across the curve ahead of Fed meeting, Dollar generally a little softer. Base metals a bit softer but gold regains $800/oz. Credit spreads in again but money mkts remain stressed.”

From UBS: “Treasuries fell after a stronger than expected home sales number, finishing 2-4 bps cheaper on the day. The low, pre-FOMC volume and balance sheet constraints had the Treasury market searching for a theme and a bid after the Pending Home Sales release. The 2s30s curve flattened 2bps. We saw very little flows and most of the action appears to be in the Bill sector--a theme of late. TIPS marginally outperformed nominals on the day, and breakevens widened 1-2bps across the board. Treasury volume was a miserly 80% of the 30-day average… Swaps saw flattener trades, and spreads went out about 0.5bps across the board. Agencies had very little in terms of flows, lagging Libor most of the way. Mortgages saw moderate origination and traded mixed to Treasuries and swaps, with the higher coupon MBS outperforming and lower coupons lagging.”

Three month T-Bill yield fell 3 bp to 3.03%.
Two year T-Note yield rose 6.5 bp to 3.17%
Ten year T-Note yield rose 5 bp to 4.15%
Dow rose 101 to 13,727
S&P 500 rose 11 to 1516
Dollar index fell .25 to 76.04
Yen rose .04 to 111.71 per dollar
Euro rose .006 to 1.471
Gold rose $14 to $809
Oil fell $.33 to $88
*All prices as of 4:40pm